Sequoia Economic Infrastructure’s chairman has bemoaned the discount widening that hit the fund over its latest reporting period, but investors may have concerns about credit quality.
Sequoia Economic Infrastructure has published annual results covering the 12 months ended 31 March 2023. Over that period, it delivered an NAV return of -0.9% and a share price return of -16.1%. By contrast, indices of high yield bonds generated total returns of -4.7%, and leveraged loans -4.2%.
The dividend was upped by 5% to 6.5625p and this was covered by cash generated by the portfolio by 1.21x. The target for the current year is 6.875p, a 10% increase.
Robert Jennings’ chairman’s statement identifies the problem as rising interest rates. As yields rise, that puts downward pressure on valuations but it does improve the company’s income stream, hence the higher dividend. His statement points out that the fall in NAV does not represent a permanent loss of capital – [barring unforeseen issues, the nominal value of the debt repaid on the maturity date remains the same].
The chairman has much to say on the share price, which we reproduce here:
“We are disappointed in this fall in our share price, which we believe is predominantly a result of investors’ concerns over rising interest rates, high inflation, a sluggish global economy and geopolitical risks, as well as technical factors specific to investors but unrelated to the company, such as the consequences of redemptions from their own funds. We do not believe it is a reflection of the fundamental attractiveness of the company – all our peers in the infrastructure and debt sectors also trade at a discount. However, we are not complacent and the following measures were put in place from an early stage to address this issue:
- an active buy-back programme, with 33.4m shares repurchased over the financial year, which we have continued since the year end. Not only does this partly address the excess supply of shares in the market, but most notably the purchases are accretive to NAV;
- ongoing share purchases by the directors of the company and Sequoia Investment Management Company Limited (the investment adviser) and its directors. In total, 1,609,258 shares were bought by insiders during the year;
- a 10% increase in the dividend, keeping pace with UK inflation, which should improve the attractiveness of the company to investors looking for strong income; and
- enhanced investor communication including a revamped website (www.seqi.fund), a well-attended investor capital markets day and numerous meetings with individual investors.”
Where the investment case might fall down is if defaults rise as economic conditions become more difficult. The existing problem loans within the portfolio – Bulb Energy and a loan backed by a property at 4000 Connecticut Avenue, Washington DC (formerly called Whittle Schools), which account for about 3.3% of the fund – are discussed below. There is another 10% of the portfolio that is “receiving enhanced scrutiny” by the investment adviser. [Losses here would go some way to justifying the discount, but at 19% it still seems a bit excessive to us, and remember that SEQI may have security over assets that can be sold to repay the debt.]
Extracts from the advisers’ report
As it has been a volatile year for asset valuations, it would be sensible to compare the performance between the first and second half of the financial year. It is important to note that given the continuous increase in interest rates and credit spreads, the investment adviser is not expecting a complete reversal of negative movements in asset valuations but is more focused on a slowing trend and a stabilising portfolio.
To capture these characteristics, the portfolio has been split into two categories, namely cashflow-based valuations and recovery-based valuations.
Cashflow-based valuations
Cashflow-based asset valuations constitute investments whose cashflows are reasonably predictable and can therefore be analysed using a discounted cashflow model. Valuation decreases for assets that are marked via this methodology are predominantly driven by systematic inputs such as the previously mentioned increase in long-term rates and credit spreads. As these do not represent underlying underperformances of the assets, the Investment Adviser expects the majority of unrealised losses to be recovered as the investments reach maturity.
Of the 9.86p per share total loss due to market movements over the financial year, a valuation loss of 6.42p can be attributed to cash-flow based valuations. Further decomposing the negative movement, almost the entirety of this negative movement, 6.41p, was recognised in the first half of the year, while a minimal further loss of 0.01p has been recorded for the second half. The explanation for this substantial improvement is a stabilising of long-term interest rate forecasts towards the end of the year, which allowed credit spread tightening and the natural pull-to-par of the portfolio’s asset to counter the loss of valuation due to risk-free rate adjustments. While a 6.42p loss in valuations for the full year remains, the investment advisor expects further price appreciation of these assets as they pull-to-par and eventually get repaid at their maturity.
Recovery-based valuations
Whilst cashflow models may still be used to value assets in this category, the Investment Adviser tracks their development more closely and uses additional valuation methodologies to assess idiosyncratic risks and eventual recoverability of these assets. This category therefore contains investments with an above-average degree of uncertainty on future price appreciation.
The remaining 3.44p loss in valuation of the total 9.86p decline due to market movements falls into this category. In the first half of the financial year, a loss of 2.18p was due to these investments, of which 1.47p was attributable to Bulb, Salt Lake Potash and Whittle Schools. An additional decline of 1.26p was recognised in the second half of the year, with a 0.35p loss due to the remaining non-performing loans. While this indicates that progress has been made on this category of assets, systemic factors such as long-term interest rates and credit spreads evidently play a lesser role in the valuation recovery than for cashflow‑based valuations. Therefore, the potential reversal of negative market movements for these investments may be slower and less predictable.
Given that the portfolio has outperformed UK mid cap equities, leveraged loans and high-yield bonds, and supports evidence of future NAV appreciation, the investmentadviser wishes to reiterate why such outperformance can be achieved:
- resilience of infrastructure debt by leveraging the inherent defensive attributes of infrastructure assets and the strong asset backing typically associated with our loans;
- mitigation of interest rate sensitivity through a significant proportion of floating rate debt in the portfolio (58%), resulting in a low level of sensitivity to changes in interest rates; and
- enhanced portfolio diversification by investing across various sectors, sub-sectors and jurisdictions, thereby minimising the impact of country-specific political and economic risks.
Non-performing loans
The status of the two remaining non‑performing loans is as follows:
1. US private school
A loan secured on a large building in a prime area in Washington D.C., originally occupied by a private school under a long-term lease agreement. Mostly as a consequence of the COVID-19 pandemic, enrolments at the school declined to the point where it could not cover its operating costs, which ultimately led to its insolvency. The loan was amended and extended in May 2022 to allow the borrower to deliver on its business plan after the COVID-19 pandemic but the school failed to recover and was then formally evicted from the property on 19 October 2022. The owner of the property continues to market it to other potential tenants, predominantly in the education sector, with an encouraging early response from a number of educational and governmental entities. However, the commercial real-estate market continues to suffer globally as a result of reduced demand, remote work, economic uncertainty, and shifts in consumer behaviour. All these factors have contributed to a valuation decline during the year. As at 31 March 2023, the value of this loan is 2.2% of the portfolio.
2. UK energy supply company
The Investment Adviser has made substantial progress on recovering value from the Fund’s loan to Bulb Energy, a UK energy supply company. During the year, the Company became the majority shareholder, through a partial debt‑for‑equity swap, of Zoa, a newly formed business set up to market Bulb’s best-in-class software to energy supply companies in the UK and elsewhere. The Fund still maintains a claim on the assets of Bulb and its parent Simple Energy and has recovered c.£14 million in cash since Bulb went into administration. The combined value of the Fund’s shares in Zoa and its loan to Bulb is 1.1% of the portfolio.
SEQI : Sequoia Economic Infrastructure chairman bemoans discount widening